Wednesday, January 7, 2009

Debt crisis can't be fixed with more debt

The chart below explains what is happening and why bankers, particularly the Fed, are panicking. It is a chart of household debt outstanding in the U.S. and you can look at it in its original form at a Federal Reserve website:

That flattening at the right end of the first chart is new and tells what is coming. Debt obligations are starting to decline in this country. Bankers hate that. Do you notice how our officials keep trying to say that they are trying to stimulate the banks to get them lending again? Do you know that bankers make much of their money by getting people into debt? Do you know that the reason we are in such a terrible economic situation right now is because everyone (i.e. households, businesses and the government) took on too much debt?

If the problem is too much debt, why would the government want to encourage more debt creation? It's a valid question, isn't it? If people are losing jobs left and right, housing prices are falling, and business prospects are poor, why would any sane banker lend more money to people or businesses? I'll tell you the secret - they won't.

Instead, the government will expand its balance sheet and put every U.S. citizen on the hook for the debt it will create. Obama and Co. are already planning another trillion or so in economic "stimulus" and that's just his first round. By the way, this doesn't count the expense of his inauguration party, which I'm sure will be very modest, cost only a few hundred bucks and have a BYOB motif. The money used by the government to "stimulate" the economy will do the exact opposite and will worsen this recession and turn it into the second great depression.

Do you doubt this? Do you know that the government caused the first great depression? If they would have let the markets restore order, a deep 2-3 year recession would have fixed the problem. Oh, no. They stimulated the living crap out the economy. They lowered interest rates aggressively, they handed out cash like it was going out of style, they created jobs for millions, they took over bad home loans, they even bought commodities and destroyed them to "stabilize" prices. All of these measures failed, just as they have failed in Japan over the past 18 years, and as they fail every time they are tried.

A debt crisis cannot be solved by taking on more debt! Period. End of story. Common sense cannot be discredited by those with PhDs.

Think of the real world. Uncle Lenny takes on home and car loans slightly above his means, then drinks away his paychecks and can't make the payments. He borrows from his relatives to make up the shortfall each month and squeaks by, until he gets into trouble with gambling debts. Then he gets a consolidation loan with a longer re-payment plan, pays back some of his relatives, and starts to make the consolidated loan payments for a few months. Just when things seem like they might be OK, Uncle Lenny loses his job. He starts using credit cards to make his monthly payment obligations until he maxes out a few too many cards, then transfers the balances to other credit cards until finally he is too maxed out and can't get any more credit.

If interest rates are lowered to 0.00001%, Uncle Lenny still cannot make the minimal payments as the principal has simply become too high. Interest rates become irrelevant when debt loads are too high. Think about borrowing $5 billion. Even with an interest rate of zero, you can't make the payments (unless you're Madoff). The only option for Uncle Lenny at this point is bankruptcy (or winning the lottery). The last thing Uncle Lenny needs is to take on another loan and who in his or her right mind would want to give him one anyway?

We have debt overload. The U.S. consumer is finally ready to retrench (i.e. stop spending and start saving). People have been calling for the death of the U.S. consumer for more than 15 years and it is finally here. Yes, we will still spend more than other cultures, but most of us are going to be forced to start thinking twice before paying $5 for a cup of coffee out of necessity. Saving money is a good thing, isn't it?

The flattening out of the chart above is an historic event in the current credit market-driven cycle. It is the concrete proof of deleveraging and the popping of the world's greatest debt bubble. When debts fail to be repaid, bankers get crushed. Defaults are death blows to bankers. The housing crash and commercial real estate crash, which are both moving ahead full steam, are going to cripple the banking system in this country for another few years. Many more bank failures are coming.

Bankers who are insolvent and have been burned by lenders will not lend freely for awhile, as this will only compound their losses. This thwarts the Fed's efforts to "stimulate" the economy. Piling debt on top of a collapsing debt bubble will not work, though it may prompt a currency crisis down the road. The last debt collapse led to the first so called great depression. Why should this time be any different?

We have extended this credit cycle beyond what anyone could have imagined and the hangover as all this debt implodes should not be underestimated. Think defaults on home loans, commercial real estate loans, credit card loans, student loans, car loans, and boat/RV/motorcycle/ATV loans. The government will try to "pick up the slack" by piling on more debt. This at a time when U.S. taxpayers have less money to pay taxes due to job losses, will owe less due to income declines and tax breaks, and will demand greater government services to tide them over until they can get back on their feet. Not only this, but the rest of the world will have less money to invest in our bonds/new government debt as they will be tending to their own internal problems.

One thing's for sure: it won't be pretty and stocks won't be a good buy and hold investment for the next several years.